Why Too Big to Fail Is Still a Problem

WASHINGTON -- A year after Congress passed a landmark law intended to tame the excesses that produced the financial crisis, some experts contend that a crucial vulnerability remains: The largest financial institutions are still so enormous that their failure could again bring the financial system to the brink of disaster.

The passage of the Dodd-Frank law has sowed a perception of safety that has spawned a dangerous complacency, they add.

"The next crisis will happen sooner rather than later," said Anat Admati, a professor of finance and economics at the Stanford Graduate School of Business. "We're not safer and there's still a lot of systemic risks in large banks and in the financial sector overall."

A central aim of the law, known as the Wall Street Reform and Consumer Protection Act, was to undercut the assumption that some institutions are so big that their potential failure could again force the government to rescue them, rather than allow their troubles to trigger another crisis. The very perception that the government stands ready to rescue the largest banks tends to be construed by the markets as a government insurance policy -- one that encourages the executives at such institutions to take bigger risks.

But on the first anniversary of the act's passage, the nation's largest banks boast larger holdings than ever. Their political clout is on the rise, say experts, and the government regulators who are supposed to be looking out for the next wave of reckless speculation are starved of cash. Meanwhile, stalwart banking industry allies in Congress are seeking to crimp the authority of the regulators on multiple fronts.

In short, assert some experts, the problem posed by institutions seen as Too Big To Fail is itself bigger than ever.

"The structural problems are worse," said Simon Johnson, a professor at the MIT Sloan School of Management and a former chief economist at the International Monetary Fund. "Their size, incentives -- none of that has changed."

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Obama administration officials maintain that the new law has contributed to greater stability in the financial system and rolled back the problem of Too Big To Fail institutions by limiting the circumstances in which the government can mount a rescue.

"It's one of these things that I think in the end people might not believe until they actually see one fail and have the government not step in," a senior Treasury Department official said last week. "But there is no authority as a matter of law for the government to commit taxpayer money in that circumstance."

Others argue that the financial system is today safer than before for the simple reason that the people working within it have gained valuable lessons.

"So much has been learned about risk management, securitization and the rest," said Ernest Patrikis, a former general counsel at the Federal Reserve Bank of New York and now a partner at the law firm White & Case. "We're safer because of the experience."

But the consequences of a potential collapse of a major American lender have grown, if for no other reason than the dollar values at stake are larger.

The assets held by the five largest American banks -- Bank of America, JPMorgan Chase, Citigroup, Wells Fargo and Goldman Sachs -- grew 3 percent last year compared to the year prior, according to their most recent quarterly filings with the Securities and Exchange Commission. They held $8.7 trillion in assets as of June 30, compared to $8.4 trillion the same time last year.

"The fact is everyone views the top six banks as too big to fail," said Admati, a member of the Federal Deposit Insurance Corporation's Systemic Resolution Advisory Committee, referring to a group that also includes Morgan Stanley. Collectively, those institutions hold close to two-thirds of the entire U.S. banking industry's assets, Federal Reserve data show.

Johnson, also a member of the FDIC's systemic committee, argues that once boom times inevitably return, these same institutions can take the same kind of risks without fear of failure: If trouble emerges, they can count on the government bailing them out again, given the alternative -- another full-blown crisis.

The Obama administration has emphasized the need to limit the vulnerability to banks that are so big that their demise would have broad repercussions. During a discussion of the economy and financial reform last year, Obama's former top economic adviser, Lawrence H. Summers, said Too Big To Fail was "in many ways the central challenge here."

"When institutions are too big to fail, they gain a competitive advantage from the sense of government support," Summers explained. "And that gives them an unfair competitive advantage. They are then able to take risks without market discipline, and when they take those risks, then they fail. And if they're too big to fail, taxpayers are on the hook and the rest of the economy suffers, as we've seen."

The distorting power of this dynamic can be huge, say experts. If creditors believe that large banks are essentially immune to normal market forces and they cannot lose money by lending to them, then they are apt to charge the banks less for their cash. If banks can borrow money on cheaper terms by dint of the perception that they can count on Uncle Sam as their guarantor, then they are more likely to take risks that would otherwise be imprudent, magnifying the risks to the system.

Money has been flowing to the largest banks on discount terms that appear to reflect the market's assumption that the taxpayer stands ready to protect them against collapse, say experts.

In 2009, this funding advantage amounted to $250 billion for 28 of the largest banks in the world, according to Andrew Haldane, the executive director for financial stability at the Bank of England.

In June 2009, the five largest U.S. banks paid creditors on average about 3.6 percent less on their long-term debt than they would have had they not been perceived to be too big to fail, according to Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City.

When banks can acquire money cheaply, they tend to distribute it more freely -- on risky loans, but also on out-sized pay packages for their employees, say experts. This enables them to lure the best and brightest minds to high finance, depriving goods-producing industries of innovative workers.

A team of economists affiliated with the Federal Reserve Bank of Cleveland determined last year that the pay of banking and finance executives was more associated with the size of the financial institution than its operating efficiency.

"This kind of pay structure might have encouraged managers to grow the sizes of the financial institutions they work for at the expense of the returns on the capital invested," the team concluded in their study.

"These distortions must be addressed," Admati said.

The Treasury official emphasized that regulators are today substantially disinclined against rescuing major financial institutions, which limits the risks being taken by such lenders. Though officials acknowledge that taxpayer funds could be used as a stopgap measure as the government supervises the orderly unwinding of troubled institutions, the new law enables federal authorities to recoup those funds from surviving firms.

Experts question whether that scenario would really play out.

"Surviving institutions are likely to be stressed themselves in the event of a crisis," Thomas F. Cooley, an economics professor at the New York University Stern School of Business, said during a panel discussion on the financial reform law last month. And the fact that companies may be forced to pay up after the fact "may encourage them to take additional risk," he said.

Whatever the merits of the Dodd-Frank act, some question whether it will ever be sufficiently implemented. The 848-page piece of legislation set out roughly 400 rules governing home mortgages and consumer credit, as well as the trading of the exotic financial instruments known as derivatives. Not least, it laid out fresh restrictions on how and when government can use taxpayer funds to rescue a teetering bank.

The law was designed to make it exceedingly difficult for regulators to resort to bailouts going forward, but the market has yet to show signs that it believes that message: Major credit rating agencies continue to certify the debts of major banks as rock-solid, in part because of the assumption that they enjoy implicit government support.

But a year after its passage, only 38 of its roughly 400 new rules have been finalized, according to a July 1 review conducted by law firm Davis Polk & Wardwell. Nearly as many deadlines for new rules have been missed.

Some experts say this reflects considerable efforts by banking industry allies to hamstring the regulators as they seek to follow through. Republicans in Congress are determined to either repeal the law, trim portions of it, or -- if all else fails -- starve regulators of much-needed cash, say observers.

"Dodd Frank has tried to equip regulators with more tools, but there's so much push back from the financial industry that what emerges in the implementation of those regulations remains to be seen," said Raghuram Rajan, an economist and finance professor at the University of Chicago's Booth School of Business, and a former chief economist at the IMF. "There's still a question as to whether regulators will implement rules in the spirit of the legislation."

Goldman Sachs executives have held at least 83 meetings with five of the federal agencies regulating the financial system since Dodd-Frank went into effect, according to the Sunlight Foundation, a Washington-based transparency advocacy group.

JPMorgan Chase representatives have met with the agencies at least 73 times. Federal regulators have met with Morgan Stanley executives at least 58 times, while Bank of America executives have held 55 meetings.

The new rules are "already being gamed to death," Federal Reserve Bank of Kansas City President Hoenig said last month.

The lobbying campaign appears to be producing gains. Earlier this year, federal bank regulators allowed some of the largest banks to resume paying dividends to their investors, even though new rules governing bank capital had yet to be finalized.

This was "the most outrageous thing regulators did," Admati said in an email. "There is NO justification for it that I heard from anyone who knows anything about this."

The banks say they have plenty of capital, and that they will meet regulators' targets through retaining a portion of their future profits.

Admati say such assurances are not enough, and she pointedly dismisses the notion that the awful experience of the last financial crisis provides comfort against a repeat. Banks continue to rely on borrowed money, she noted, with debt financing about 90 percent of their assets, according to the FDIC.

Five years ago, equity funded about 10.4 percent of the banking system's assets, FDIC data show -- a figure that experts now generally see as woefully inadequate. In the wake of the worst crisis since the Great Depression, that's risen to just 11.3 percent, according to data as of March 31.

"We're missing the big picture when it comes to systemic risk," Admati said.